Over at the Volokh Conspiracy, Ilya Somin talks about the possible abolition of the mortgage interest tax deduction.

As many have pointed out, such an abolition would run against the reliance interest of current homeowners. When budgeting for a house, they assumed that they would get to deduct the interest on their mortgage payments and abolishing that deduction might put a big hole in their budget. Ilya implicitly brings up as a solution the idea of abolishing the mortgage interest deductions only for new house sales.

Regardless the reliance argument does not apply to new purchases that occur after the deduction has been abolished. For them, abolition can be immediate.

This is a mistake for several reasons. First, current homeowners do have a reliance interest in home-buyers benefiting from the deduction. If home-buyers can expect to get the deduction, they will be willing and able to pay more for houses. This is something that homeowners relied upon when they bought their houses. If the deduction is abolished, this could mean a significant hit to home values and whatever plans homeowners may have made relying upon that home value could be disrupted.

Second, and I think much more importantly, this would create a harmful discontinuity in the real estate market: If you currently have a mortgage, you would have an incentive to stay in your current house for longer than optimal in order to avoid giving up the deduction. Otherwise, you would have to settle for a cheaper place/dig into your capital/pay a higher mortgage.

Let’s do a simple illustrative example: You have a house with a $100,000 mortgage and you still owe $50,000 to the bank. The mortgage interest deduction is abolished causing house values to fall by 10%, but you still keep the deduction on your current mortgage. Your house is now worth $90,000. Now you consider moving into an identical house. Well, first, you sell your current house, get $90,000, pay $50,000 to the bank and get to keep $40,000. You buy an identical house for $90,000 a $40,000 down-payment and a $50,000 loan. You’re back where you started right? No. Because you now pay taxes on your mortgage interests which means you have to choose: higher monthly payments, buy a cheaper house or get a longer loan. Or of course, stay in your old house.

I favor abolishing the mortgage interest deduction, but we shouldn’t differentiate old and new mortgages.

On the other hand, the phase-out that Ilya mentioned is in my opinion absolutely necessary. Doing it in one go would mean a significant hit to the wealth of homeowners which could be problematic in the current slump.

[UPDATE] Ilya responds. He is of course correct that a gradual phase-out would soften the market distortion relative to simply grandfathering in existing mortgages.

When it comes to whether we should phase out the deduction or just make a clean cut, I understand Ilya’s eagerness, but I think it would be a mistake. A lot of people have a lot of their wealth tied in the value of their house. A sudden drop could cause a fall in nominal spending through the wealth effect which could have serious consequences for the economy as a whole. I think a multi-year phase-out would be much more preferable.

3 Responses to Abolishing The Mortgage Interest Deduction On New Purchases Only Also Runs Against A Reliance Interest

It seems like the second problem is easily solved: at the time the deduction is abolished, it’s grandfathered in for existing mortgage-holders, in the amount that would have been deductible if the existing mortgage were paid off in good faith.

So, if you have $50K left on your mortgage, and you move, and get a new mortgage for $50K, you keep the deduction until the new mortgage is paid off on the same terms. If you move to a bigger house, and get a new mortgage for $100K, half your interest is deductible (assuming your new mortgage is at the same rate for the same term).

I don’t have a huge problem with house prices dropping based on the absence of the deduction. If it’s an investment property … well, there’s legislative risk in any investment, and nobody ever promised the deduction would stay forever. If it’s not an investment property, and you’re living in it, you won’t notice a hit until you downgrade houses, which probably won’t be for many years. And if you upgrade houses in the meantime, you’ll benefit rather than lose.